Forbearance and Prompt Corrective Action

27 Pages Posted: 20 Sep 2007

See all articles by Narayana Kocherlakota

Narayana Kocherlakota

University of Minnesota - Twin Cities - Department of Economics

Ilhyock Shim

Bank for International Settlements (BIS)

Date Written: March 15, 2006

Abstract

This paper investigates whether a bank regulator should terminate problem banks promptly or exercise forbearance. We construct a dynamic model economy in which entrepreneurs pledge collateral, borrow from banks, and invest in long-term projects. We assume that collateral value has aggregate risk over time, that in any period entrepreneurs can abscond with the projects but losing the collateral, and that depositors can withdraw deposits. We show that optimal regulation exhibits forbearance if the ex-ante probability of collapse in collateral value is sufficiently low, but exhibits prompt termination of problem banks if this probability is sufficiently high.

Keywords: risky collateral, limited enforcement, banking regulation, optimal social contract

JEL Classification: G21, G28, D81

Suggested Citation

Kocherlakota, Narayana and Shim, Ilhyock, Forbearance and Prompt Corrective Action (March 15, 2006). BIS Working Paper No. 177. Available at SSRN: https://ssrn.com/abstract=735323 or http://dx.doi.org/10.2139/ssrn.735323

Narayana Kocherlakota

University of Minnesota - Twin Cities - Department of Economics ( email )

271 19th Avenue South
Minneapolis, MN 55455
United States
612-625-5318 (Phone)
612-624-0209 (Fax)

HOME PAGE: http://www.econ.umn.edu/~nkocher/

Ilhyock Shim (Contact Author)

Bank for International Settlements (BIS) ( email )

78F, Two International Finance Centre
8 Finance Street, Central
Hong Kong, n/a n/a
Hong Kong

HOME PAGE: http://www.bis.org/author/ilhyock_shim.htm

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